Heads-Up5: FCFE with debt ratio and 2 stages

Good luck. Not too hard but you just need to keep things in order.

The Hoffman Card Co. earned £1.50 per share last year. Investment in fixed capital was £0.80 per share, and depreciation was £0.30. Investment in working capital was £0.20 per share.

Hoffman expects earnings to grow at 15% per year for the next five years and that investment in fixed capital, depreciation, and investment in working capital will grow at the same rate. After five years, the growth in earnings and working capital requirements will decline to a stable 5% per year, and investment in fixed capital and depreciation will offset each other (i.e., they will be equal). Hoffman’s target debt ratio is 30%.

The shareholders require a return of 17% on their investment during the high-growth stage and a return of 10% on their investment during the stable stage.

The FCFE in Year 6 and the value per share of Hoffman’s common stock are closest to:

FCFE in Year 6 … Share value

A. £2.03 … £31.08

B. £2.88 … £31.08

c. £2.88 … £57.60

Hint: Do not try to learn new formulas. To calculate FCFE with debt impact start with your usual FCFE formula:

FCFE = NI + NCC + Net borrowing - FCInv - WCinv

Then adjust net borrowing = (FCInv - Depr + WCInv) * debt ratio, and plug above. The book asks you to memorize yet another formula…ugh.

Where is this from? Don’t we need net borrowing?

There’s a magical alternative to net borrowing, and that’s by multiplying your FCInv, WCInv, and NCC by (1-debt ratio).

Hell no I’m not learning that one as I haven’t seen it in any of my practice tests. If that gets me on test day so be it, knocks on wood.

Without the borrowing I’m assuming 1.5-.8-.2+.3 = .8 x 1.15^5 since the WC FC all move in proportion, then multiply by 1.05?

It’s straightforward, give it a try, and use the formula I mentioned above to keep things simple.

Also, you don’t need to calculate all the values for years 1-4, mostly you need years 5 and 6.

answer is B. £2.88 ……………. £31.08

this formula is easier to remember when given the Debt ratio, FCFE = NI - {(1-DR)(FCInv - Depr + NWCinv)}

worth remembering this derivation of FCFE

nope not me, I try to memorize formulas as little as possible…start with the original always.

Thats a good one.

Can’t get FCFE. First year FCFE = 1.50 + .21 + . 3 - .8 - .2 = 1.01.

1.01 * (1.15)^5 * 1.05 = 2.13.

In year 6, it says " investment in fixed capital and depreciation will offset each other".

KYS - to find FCFE for year 6, you just need to forecast out earnings and WCINV.

Thanks guys. I keep screwing up in the mocks because I skim the questions